VC Myths and a Dose of Reality

Venture capital has an important role to play in the creation and growth of new firms—but let’s not get carried away. That is the primary message from a former VC in a new article in the Harvard Business Review. This shouldn’t come as a surprise to regular PDE followers, but there are a number of common misconceptions about the scope, performance and success rate of venture capital for startups.

Diane Mulcahy, director of private equity at the Kauffman Foundation, debunks six widely held myths in the HBR article.

Myth 1: Venture Capital is the Primary Source of Startup Funding
VC financing is the exception, not the norm, for startups. Historically, less than 1 percent of U.S. companies have raised capital from VCs, and the VC industry is contracting. But less venture capital does not mean less startup capital since non-VC sources of funding, such as angel capital, are growing.

Myth 2: VCs Take a Big Risk When They Invest in Your Company
VCs take risks with investors' money, not their own. The typical VC commits only 1 percent of partner capital to a fund while investors commit the remaining 99 percent. The VC revenue model that generates guaranteed and cumulative management fees regardless of investment performance insulates VC partner personal compensation from the risk of poor returns.

Myth 3: Most VCs Offer Valuable Advice and Mentoring
VCs differ in how much effort they put into these nonmonetary resources, and the quality of advice and mentoring from VCs can vary widely, so founders who want more than capital from their investors should conduct a thorough due diligence on a VC firm they are considering.

Myth 4: VCs Generate Spectacular Returns
Mulcahy cites the data and findings from the Kauffman Foundation report she and her colleagues published last year about the under-performing VC industry. The report provides data on historic VC industry returns, and the Kauffman Foundation's experience as a long-term investor in VC funds.

Myth 5: In VC, Bigger is Better
The contrary is true for both the industry and individual funds. Industry and academic studies show that VC fund performance declines as fund size increases above $250 million.

Myth 6: VCs are Innovators
VCs may be well known for funding innovation, but the VC industry and business model have not seen significant innovation in two decades. The VC fund structure, fund life and economic terms have remained the same for more than 20 years. Note to GPs: Increasing the standard 2 and 20 compensation model to 2.5 and 25 is not innovation.